The Big Bank
I am sure that you have noticed a lot of chatter about the Federal Reserve lately. You know that group of stodgy economist- bankers that control the largest economy in the world. Yep, those guys and gals that can make interest rates go up and down with a swish of a pen… er, a pencil. The Fed has 2 primary goals: fight inflation and keep unemployment low. It is known as the Fed’s “dual mandate”. Many credit the Fed’s quick action with monetary policy for getting us through 2020’s pandemic-inspired recession. It acted with lightening speed pegging its key lending rate at 0% and began to buy bonds in the open market, thus pushing yields on Treasuries and Mortgage-backed bonds lower. This so-called “easy money” allowed stressed companies and consumers to borrow money at rock bottom yields. By purchasing bonds, the Fed was also able to inject liquidity, a fancy word for cash, into the banking system enabling banks to lend more easily. The Fed orchestrated a similar recovery from the 2007/2008 Great Recession / Global Financial Crisis. I can keep going back, but you get the picture: the Fed makes borrowing money easy, and consumers/companies use that money to buy things, ultimately stimulating economic growth. So, you are probably thinking, “why doesn’t the Fed just keep rates at zero perpetually so the economy can always grow?” There is, unfortunately, a cost to “easy money”. Economies that are left to run too hot for too long generate price inflation. Oh, that is a topic I am sure that you are sick of hearing about. In today’s case, the runaway inflation we are now experiencing comes from a combination of pandemic-caused supply chain problems, the war in Ukraine choking supply of commodities (grains and energy), and…you guess it, hot demand generated by low interest rates, easy money. As you probably already know by now, Fed monetary policy works in both directions. In converse to stimulating the economy with lower interest rates, the Fed can slow down the economy by raising interest rates. The theory there works as follows. Higher borrowing costs for companies and consumers will cause them to demand and spend less. Lower demand and spending will cause price inflation to retract. That seems sensible, doesn’t it? As you may have also noticed, the stock and bond markets have not performed too well in the past 9 months or so. In fact, they started to misbehave once the Fed made it clear back in last November that it was going to have to tackle inflation by raising interest rates. Since that admission, markets have struggled to not only factor in inflation, which eats into demand and margins, but also to factor in higher borrowing costs. At first the Fed spoke of hiking slowly, but it quickly switched gears when inflation began to climb. The Fed shifted gears once again when earlier in June a hotter than expected Consumer Price Index (CPI) number hit the tape. Markets quickly adjusted, a kind way of saying sold off. So, you see that there is a direct relationship between the capital markets and Fed activity. Knowing this, would you like to know what those central bankers are predicting rates to be at by the end of this year…and next year…and the year after that? All you have to do is ask…or refer to its Dot Plot.
What in tarnation is a Dot Plot?
The Federal Reserve’s Open Market Committee (FOMC) releases a scatter plot of interest rate projections for the future. The plot is released in its March, June, September, and December meetings along with projection materials. The chart is an x y scatter plot with short term interest rates on the y-axis and with timeframes of 1 to 3 years and the “the longer term” depicted on the x-axis. Each member on the FOMC submits his or her prediction for what they believe should be the midpoint for Fed Funds at the end of each year going forward. Though all 19 members may submit projections, the voting members of the FOMC are the Federal Reserve officials who are tasked with setting interest policy, and they include: 7 members of the Fed Board of Governors, The President of the New York Federal Reserve Bank, and 4 Federal Reserve Bank Presidents from each of the remaining 11 regional reserve banks who rotate in one-year terms. The resulting 12 members meet at 8 regularly scheduled meetings per year to set rate policy and it is their projections along with non-voting participants that appear on the four dot plots released annually. The dot plot is perhaps one of the most scrutinized releases in the world as its projections come directly from policy makers. As with all things in economics, it is not without its detractors.
The history of the Dot Plot
The dot plot was first introduced by Fed Chairman Ben Bernanke in 2011. It was during that time, in the wake of the Great Recession, that the Fed was utilizing very aggressive and unprecedented accommodative policy to jumpstart the ailing economy. The Fed was still nowhere near switching gears with QE1 and QE2 having been completed in 2009 and 2011 respectively, there would still be another round of easing (QE3) in 2012. Interest rates were near zero and would not be changed until 2015. At that point, Bernanke thought that the Fed would need a way to communicate or signal any potential future changes in policy in order to soften the blow in the event of a reduction of accommodations or to ease concerns by demonstrating ongoing accommodation. In the case of taking away accommodations, economies are cyclical, and the Fed was well aware that at some point in the future it would find itself in a tightening cycle, even though it would have been unthinkable in 2011. Bernanke believed in what he termed “aggressive forward guidance” which would signal Fed intent in its Dot Plots.
How to read the Dot Plot – What do those dots mean?
Below is a Bloomberg chart depicting the June 2022 meeting’s dot plot. Each yellow dot represents an FOMC member’s prediction for the Fed Funds rate at the end of a given year. So, for example, we can see that 8 members believed that the Fed Funds Target would be at 3.4% while 5 members expect rates to be just above 3%. Those least hawkish members still believe that rates will be +150 basis points higher than where they adjusted rates to in that June meeting.
What’s more is that 5 members believe that rates will end the year higher than 3.5%! On this chart, we observe the median of the dots, or projections (depicted by the green circle and line). In this case, members predicted that rates would be at 3.4% at the end of the year, on median. As the current Fed Funds target is 1.5%, that would mean that governors are anticipating hiking by an additional +200 basis points. By looking further out into 2023, governors predict that rates would be 3.75%, meaning that they expect another +25 basis-point rate hike in that year, or more interesting yet, possibly several hikes AND cuts resulting in a 3.75% funds rate by year end. 2024’s median shows governors expecting rates to be coming down slightly, with a significant shift downward to the 2.5% neutral rate thereafter. Remember that each dot is anonymous, so we don’t know which governor made the prediction or if they are even a voting member.
Another way to observe the Dot Plot is by observing the changes in FOMC member predictions from one meeting to another. This enables us to see if sentiment is shifting to a more dovish or hawkish stance. The following chart, also from Bloomberg allows us to compare dots plots from one meeting to another. Depicted in this chart are the dot plots from March 2022 and June 2022. If you look closely at the dots for 2020, you can see that the median forecast in March was around 2% but by June, governors aggressively raised their predictions to around 3.5%. In other words, they were expecting several more rate hikes for the year. This resulted from the pickup in inflation even after many governors expected inflation to peak prior to June’s meeting. The path of higher rates remained the same, just another +150 basis points of hikes for 2022. In other words, the Fed became significantly more hawkish.
It is important to note that these are simply predictions, and they represent a snapshot in time. Those were Fed predictions at the time of the meeting. As we can see from the above chart, in this environment, lots can change, and changes can happen quickly. The optionality, as the Fed likes to call it, appears quite prominently in the following chart, which shows drastic change in views from last June to this year’s June. Last year Fed members predicted that 2022 would end the year at 0%. Talk about a change of heart.
So, it is clear, though not perfect, these dot plots are worth studying if you want to have a good idea what to expect with finances…and your portfolio in the future.
The future of the Dot Plot
You can see why so many folks: investors, Fed watchers, economists, and politicians focus so heavily on this single, obscure scatter plot. There are many critics of the Dot Plot who claim that the chart does not represent policy, that voting members submit predictions along with non-voters, and that no one, even the Fed bankers, can predict that far out into the future with any accuracy. As rate policy is data dependent, future predictions, certainly beyond 12 months are worthless, especially in today’s rapidly changing environment. Chairman Jerome Powell, himself, has publicly expressed concerns over the Dot Plot, making its future questionable. The most important thing to remember is that it is just a prediction and that the further out in time you go, the less valid the predictions will be. That said, the Dot Plot remains the single best way to gauge the current thinking of the folks who actually make the policy, the Fed’s Federal Open Market Committee members.